Millions of Americans use IRAs to save for retirement. These tax-favored retirement accounts have many benefits that can make it easier for you to accumulate a sizable retirement nest egg. When it comes time to hang up your work boots and actually start taking money out of your retirement accounts, however, it's critical to understand the tax implications of withdrawals from various types of IRAs and how to report those distributions properly on your tax returns.
The IRS requires you to report the total amount of money you've received from IRAs over the course of the tax year. But you also have to tell the tax service what portion of that amount that is taxable, and only the taxable amount gets added to your gross income. In most cases, the rules governing what's taxable and what's not are pretty straightforward, but there are special situations that require a bit more nuance in coming up with the right answer.
The general rule for taxing IRA distributions
The most important thing to know about what part of an IRA distribution is taxable is what type of IRA you took the money from. For most taxpayers, the general rule is that if you took money out of a traditional IRA, then the entire amount will be subject to tax. If you took money out of a Roth IRA, then none of it will typically be subject to tax.
The reason for this tax treatment goes back to what happened when you first made contributions to your retirement account. For traditional IRAs, most people get an up-front tax deduction, meaning that you get to put pre-tax money into the retirement account. Because neither the contributed amount nor the income and gains on those contributions were ever subject to tax, the IRS gets its cut when you take the money out of your account in retirement.
Roth IRAs work differently. You don't get an up-front deduction for a Roth contribution and instead have to use after-tax money to fund the retirement account. Because of that, the rules governing Roth IRAs let you treat the income and gains on those contributions as being tax-free as well. Therefore, when you take money out in retirement, none of the Roth proceeds typically gets taxed.
Dealing with exceptions
As with most rules, there are some cases in which different tax treatment for traditional and Roth IRA distributions is necessary. For traditional IRAs, you might have a partially nontaxable distribution if you've made nondeductible contributions to your IRA at some point in the past. In that case, you determine what fraction of your total current IRA value your nondeductible contributions made up, and then that fraction of your distribution isn't subject to tax. For instance, if you made $5,000 in nondeductible IRA contributions one year and the value of your IRA was $50,000 when you took a $2,000 withdrawal, then you'd figure that $5,000 is 10% of $50,000, and so 10% of $2,000, or $200, is nontaxable, making the remaining $1,800 taxable.
On the other hand, Roth IRA distributions can be partially taxable if you don't meet some of the rules governing them. Early withdrawals before age 59 1/2 that don't qualify for exceptions invalidate the tax-free treatment of Roth IRA earnings, and if you've had your Roth for less than five years, then a similar provision can apply even if you're older than 59 1/2. However, the rules for determining the taxable amount are different, because you're treated as taking your initial contributions on a tax-free basis first before tapping any potentially taxable earnings.
Double-check the numbers
One helpful thing that most IRA providers do is to indicate on a 1099-R form what portion of your distribution they believe is taxable. However, there's a box on the 1099-R that allows some providers not to determine the taxable amount. More importantly, your financial institution won't necessarily get everything correct, so it pays to double-check and make sure that there aren't any mistakes. If there are, you'll want to contact your financial institution to have them correct their erroneous 1099-R to prevent any red flags from coming up on your return.
IRAs are great tools for saving for retirement, but they can have big tax consequences when you start taking withdrawals. By knowing what to expect before you start taking withdrawals, you'll be in a better position to do smart tax planning and use your IRAs wisely to help you with your retirement costs.